**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM10-QSB**

 

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| x                                                                                                                                         | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|
|                                                                                                                                      |       |                                                                                               |   |
| **For  the quarterly period ended September 30, 2007**                                                                                    |
|                                                                                                                                      |       |                                                                                               |   |
| **OR**                                                                                                                                    |
|                                                                                                                                      |       |                                                                                               |   |
| o                                                                                                                                         | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                      |       |                                                                                               |   |
| For the transition  period from                   to |
|                                                                                                                                      |       |                                                                                               |   |
| **Commission  File Number 0-20191**                                                                                                       |

 

**INTRUSIONINC.**

(Exact name of smallbusiness issuer as specified in its charter)

 
| **Delaware**                                                     | ** ** | **75-1911917**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**1101East Arapaho Road, Suite 200, Richardson, Texas 75081**

(Address of principalexecutive offices)

(Zip Code)

 

**(972) 234-6400**

(Issuer’s telephonenumber, including area code)

 

**NotApplicable**

Former name, if changedsince last report)

 

* * * * * * * * * *

 

Check whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days:

Yes x No o

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act:  Yes oNo x

 

The number of shares outstanding of the Registrant’sCommon Stock, $0.01 par value, on October 26, 2007 was 11,523,726.

 

Transitional Small Business Disclosure Format (checkone):  Yes o No x

 

 

 

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**INTRUSIONINC.**

 

INDEX

 
| **PART I — FINANCIAL  INFORMATION** | ** **                                                                                                                 |
|------------------------------------------|----------------------------------------------------------------------------------------------------------------------------|
|                                     |                                                                                                                       |   |
| Item 1.                                  | Financial  Statements                                                                                                      |   |
|                                     |                                                                                                                       |   |
|                                     | Unaudited  Condensed Consolidated Balance Sheets as of September 30, 2007 and  December 31, 2006                      |   |
|                                     |                                                                                                                       |   |
| ** **                               | Unaudited Condensed  Consolidated Statements of Operations for the three and nine months ended September 30, 2007 and 2006 |   |
|                                     |                                                                                                                       |   |
|                                     | Unaudited  Condensed Consolidated Statements of Cash Flows for the nine months ended  September 30, 2007 and 2006          |   |
|                                     |                                                                                                                       |   |
|                                     | Notes to  Unaudited Condensed Consolidated Financial Statements                                                            |   |
|                                     |                                                                                                                       |   |
| Item 2.                                  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                |   |
|                                     |                                                                                                                       |   |
| Item 3.                                  | Controls and  Procedures                                                                                                   |   |
|                                     |                                                                                                                       |   |
| **PART II — OTHER  INFORMATION**    | ** **                                                                                                                 |
|                                     |                                                                                                                       |   |
| Item 1.                                  | Legal Proceedings                                                                                                          |   |
|                                     |                                                                                                                       |   |
| Item  6.                                 | Exhibits                                                                                                                   |   |
|                                     |                                                                                                                       |   |
| Signature  Page                          |                                                                                                                       |
|                                          |                                                                                                                            |  |  |  |

 

 

2

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**PARTI — FINANCIAL INFORMATION**

 

Item 1. FINANCIALSTATEMENTS

 

**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except parvalue amounts)

 
| ** **                                                                                                                            | ** ** | **Seeptember 30,******** 2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                            |       |                                 |       |                        |       |
| Current Assets:                                                                                                                       |       |                                 |       |                        |       |
| Cash and cash equivalents                                                                                                             |       | $                                    | 947        |                        | $          | 933 |   |
| Accounts receivable, less allowance for doubtful accounts of $76 in  2007 and $90 in 2006                                             |       | 407                                  |       | 844                         |       |
| Inventories, net                                                                                                                      |       | 228                                  |       | 209                         |       |
| Prepaid expenses                                                                                                                      |       | 83                                   |       | 198                         |       |
| Total current assets                                                                                                                  |       | 1,665                                |       | 2,184                       |       |
| Property and equipment, net                                                                                                           |       | 156                                  |       | 162                         |       |
| Other assets                                                                                                                          |       | 39                                   |       | 41                          |       |
| TOTAL ASSETS                                                                                                                          |       | $                                    | 1,860      |                        | $          | 2,387 |   |
|                                                                                                                                  |       |                                 |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                        |       |                                 |       |                        |       |
|                                                                                                                                  |       |                                 |       |                        |       |
| Current Liabilities:                                                                                                                  |       |                                 |       |                        |       |
| Accounts payable and accrued expenses                                                                                                 |       | $                                    | 809        |                        | $          | 1,099 |   |
| Line of credit                                                                                                                        |       | 100                                  |       | 200                         |       |
| Deferred revenue                                                                                                                      |       | 351                                  |       | 367                         |       |
| Total current liabilities                                                                                                             |       | 1,260                                |       | 1,666                       |       |
|                                                                                                                                  |       |                                 |       |                        |       |
| Stockholders’ Equity:                                                                                                            |       |                                 |       |                        |       |
| Preferred stock, $0.01 par value: Authorized shares — 5,000                                                                      |       |                                 |       |                        |       |
| Series 1 shares issued and outstanding — 260 Liquidation preference  of $1,331 as of September 30, 2007                          |       | 918                                  |       | 918                         |       |
| Series 2 shares issued and outstanding — 460 Liquidation preference  of $1,155 as of September 30, 2007                          |       | 724                                  |       | 724                         |       |
| Series 3 shares issued and outstanding — 469 Liquidation preference  of $1,026 as of September 30, 2007                          |       | 667                                  |       | 667                         |       |
| Common stock, $0.01 par value:                                                                                                        |       |                                 |       |                        |       |
| Authorized shares — 80,000                                                                                                       |       |                                 |       |                        |       |
| Issued shares — 11,534 in 2007 and 8,306 in 2006 

   Outstanding shares — 11,524 in 2007 and 8,296 in  2006 |       | 115                                  |       | 83                          |       |
| Common stock held in treasury, at cost — 10 shares                                                                               |       | (362                                 | )          | (362                        | )          |
| Additional paid-in capital                                                                                                            |       | 55,378                               |       | 53,947                      |       |
| Accumulated deficit                                                                                                                   |       | (56,661                              | )          | (55,077                     | )          |
| Accumulated other comprehensive loss                                                                                                  |       | (179                                 | )          | (179                        | )          |
| Total stockholders’ equity                                                                                                       |       | 600                                  |       | 721                         |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                       |       | $                                    | 1,860      |                        | $          | 2,387 |   |

 

See accompanying notes.

 

 

 

 

 

3

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**INTRUSIONINC. AND SUBSIDIARIES**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share amounts)

 
| ** **                                                                 | ** ** | **Three Months Ended**           | ** ** | **Nine Months Ended**            | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                 | ** ** | **September 30,**

**2007** | ** ** | **September 30,**

**2006** | ** ** | **September 30,**

**2007** | ** ** | **September 30,**

**2006** | ** ** |
| Net product revenue                                                        |       | $                                | 749        |                             | $          | 1,465 |   | $ | 2,476 |   | $ | 2,840 |   |
| Net customer support and maintenance revenue                               |       | 170                              |       | 271                              |       | 538 |   | 951 |   |
| Total revenue                                                              |       | 919                              |       | 1,736                            |       | 3,014 |   | 3,791 |   |
| Cost of product revenue                                                    |       | 355                              |       | 755                              |       | 1,129 |   | 1,441 |   |
| Cost of customer support and maintenance revenue                           |       | 15                               |       | 23                               |       | 55 |   | 183 |   |
| Total cost of revenue                                                      |       | 370                              |       | 778                              |       | 1,184 |   | 1,624 |   |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Gross profit                                                               |       | 549                              |       | 958                              |       | 1,830 |   | 2,167 |   |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Operating expenses:                                                        |       |                             |       |                             |       |   |   |   |   |
| Sales and marketing                                                        |       | 499                              |       | 562                              |       | 1,518 |   | 2,227 |   |
| Research and development                                                   |       | 358                              |       | 272                              |       | 1,169 |   | 1,679 |   |
| General and administrative                                                 |       | 255                              |       | 306                              |       | 730 |   | 1,039 |   |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Operating loss                                                             |       | (563                             | )          | (182                             | )          | (1,587 | ) | (2,778 | ) |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Other income (expense), net                                                |       | —                           |       | —                           |       | 1 |   | (65 | ) |
| Interest income (expense), net                                             |       | 1                                |       | 2                                |       | 2 |   | 43 |   |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Loss before income tax provision                                           |       | (562                             | )          | (180                             | )          | (1,584 | ) | (2,800 | ) |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Income tax provision                                                       |       | —                           |       | —                           |       | — |   | — |   |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Net loss                                                                   |       | $                                | (562       | )                                | $          | (180 | ) | $ | (1,584 | ) | $ | (2,800 | ) |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Preferred stock dividends accrued                                          |       | (44                              | )          | (44                              | )          | (130 | ) | (132 | ) |
| Net loss attributable to common stockholders                               |       | $                                | (606       | )                                | $          | (224 | ) | $ | (1,714 | ) | $ | (2,932 | ) |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Net loss per share attributable to common stockholders, basic and  diluted |       | $                                | (0.06      | )                                | $          | (0.03 | ) | $ | (0.18 | ) | $ | (0.42 | ) |
|                                                                       |       |                             |       |                             |       |   |   |   |   |
| Weighted average common shares outstanding, basic and diluted              |       | 10,397                           |       | 7,046                            |       | 9,387 |   | 7,025 |   |

 

See accompanying notes.

 

 

 

 

4

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**INTRUSIONINC. AND SUBSIDIARIES**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)

 

 
| ** **                                                                   | ** ** | **Nine Months Ended**   | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                   | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
| Operating Activities:                                                        |       |                    |       |   |   |
| Net loss                                                                     |       | $                       | (1,584     | ) | $ | (2,800 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                    |       |   |   |
| Depreciation and amortization                                                |       | 45                      |       | 80 |   |
| Provision for doubtful accounts                                              |       | (14                     | )          | (13 | ) |
| Stock-based compensation                                                     |       | 93                      |       | 402 |   |
| Changes in operating assets and liabilities:                                 |       |                    |       |   |   |
| Accounts receivable                                                          |       | 451                     |       | (465 | ) |
| Inventories                                                                  |       | (19                     | )          | 134 |   |
| Prepaid expenses and other assets                                            |       | 117                     |       | 128 |   |
| Accounts payable and accrued expenses                                        |       | (305                    | )          | (209 | ) |
| Deferred revenue                                                             |       | (16                     | )          | (166 | ) |
| Net cash used in operating activities                                        |       | (1,232                  | )          | (2,909 | ) |
| Investing Activities:                                                        |       |                    |       |   |   |
| Maturities of short-term investments                                         |       | —                  |       | 500 |   |
| Purchases of property and equipment                                          |       | (39                     | )          | (3 | ) |
| Net cash provided by (used in) investing activities                          |       | (39                     | )          | 497 |   |
| Financing Activities:                                                        |       |                    |       |   |   |
| Net activity under line of credit                                            |       | (100                    | )          | — |   |
| Dividends paid on preferred stock                                            |       | (115                    | )          | (133 | ) |
| Proceeds from the issuance of common stock                                   |       | 1,500                   |       | 1 |   |
| Net cash provided by (used in) financing activities                          |       | 1,285                   |       | (132 | ) |
|                                                                         |       |                    |       |   |   |
| Net increase (decrease) in cash and cash equivalents                         |       | 14                      |       | (2,544 | ) |
| Cash and cash equivalents at beginning of period                             |       | 933                     |       | 2,844 |   |
| Cash and cash equivalents at end of period                                   |       | $                       | 947        |   | $ | 300 |   |
|                                                                         |       |                    |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH FINANCING ACTIVITIES:                    |       |                    |       |   |   |
|                                                                         |       |                    |       |   |   |
| Preferred stock dividends accrued                                            |       | $                       | 130        |   | $ | 132 |   |

 

See accompanying notes.

 

 

 

 

 

5

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**INTRUSIONINC. AND SUBSIDIARIES**

NOTES TO UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.     Descriptionof Business

 

Wedevelop, market, and support a family of entity identification, regulatedinformation compliance, data privacy protection, and network intrusionprevention and detection products.  Ourproduct families include TraceCopTM for identity identification, the ComplianceCommanderTM for regulatedinformation and data privacy protection, and Intrusion SecureNet for networkintrusion prevention and detection. Intrusion’s products help protect critical information assets by quicklydetecting, protecting, analyzing and reporting attacks or misuse of classified,private and regulated information for government and enterprise networks.

 

Wemarket and distribute our products through a direct sales force to end-users,distributors and numerous system integrators, managed service providers andvalue-added resellers. Our end-user customers include banks, credit unions,other financial institutions, U.S. federal government entities, foreigngovernment entities and local government entities, high technology, e-commerceand telecommunication companies, hospital and other healthcare providers andacademic institutions.  Essentially, ourend-users can be defined as ‘any end-user requiring network security solutionsfor protecting their mission critical data’.

 

Wewere organized in Texas in September 1983 and reincorporated in Delawarein October 1995. For more than 15 years, we provided local areanetworking equipment and were known as Optical Data Systems or ODS Networks. OnJune 1, 2000, we changed our name from ODS Networks, Inc. toIntrusion.com, Inc., and our ticker symbol from ODSI to INTZ to reflectour focus on intrusion prevention and detection solutions, along withinformation compliance and data privacy protection products. On November 1,2001, we changed our name from Intrusion.com, Inc. to Intrusion Inc.

 

Our principal executive offices are located at 1101East Arapaho Road, Suite 200, Richardson, Texas 75081, and our telephone numberis (972) 234-6400.  Our website URL iswww.intrusion.com.  Information containedin or linked to our website is not a part of this report.  References to “we,” “us” and “our” in thisreport refer to Intrusion Inc. and its subsidiaries.

 

As of September 30, 2007,we had cash and cash equivalents of approximately $0.9 million, compared toapproximately $0.9 million as of December 31, 2006.  Net operating losses and operating cashoutflows may continue in the fourth quarter of 2007 and possibly into 2008.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources.  Of the $0.9 million in cash and cash equivalents at September 30, 2007,$0.5 million was derived from a private investment by our Chief ExecutiveOfficer which closed on September 26, 2007.  As of September 30, 2007, we had approximately an additional $100thousand available under our existing credit lines.  If necessary, we expect to fund ouroperations through additional investments of private equity, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyadditional equity or debt financings, if available at all, may be on terms whichare not favorable to us and, in the case of equity financings, may result indilution to our stockholders. If our operations do not generate positive cashflow in the next few months, or if we are not able to obtain additional debt orequity financing on terms and conditions acceptable to us, if at all, we may beunable to implement our business plan, fund our liquidity needs or evencontinue our operations.

 

2.     Basis ofPresentation

 

The accompanying unaudited condensed consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Form 10-QSB and Item 310 of RegulationS-B.  Accordingly, they do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.  The December 31, 2006 balance sheet wasderived from audited financial statements, but does not include all the disclosuresrequired by accounting principles generally accepted in the United States.  However, we believe that the disclosures areadequate to make the information presented not misleading.  In our opinion, all the adjustments (consistingof normal recurring adjustments) considered necessary for fair presentationhave been included.  The results ofoperations for the three and nine month periods ending September 30, 2007 arenot necessarily indicative of the results that may be achieved for the fullfiscal year or for any future period. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in the Company’s annual report on Form 10-KSB forthe year ended December 31, 2006.

 

6

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3.     Inventories(In thousands)

 
| ** **              | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                    |       |                    |       |                        |       |
| Inventories consist of: |       |                    |       |                        |       |
|                    |       |                    |       |                        |       |
| Finished goods          |       | $                       | 206        |                        | $          | 180 |   |
| Work in progress        |       | 8                       |       | 8                           |       |
| Demonstration systems   |       | 14                      |       | 21                          |       |
| Net inventory           |       | $                       | 228        |                        | $          | 209 |   |

 

4.     Accountingfor Stock-Based Compensation

 

AtSeptember 30, 2007, we have three stock-based compensation plans, which aredescribed below. These plans were developed to retain and attract key employeesand directors.

 

In1995, we adopted our 1995 Stock Option Plan (the “1995 Plan”), which providesfor the issuance of up to 400,000 shares of common stock upon exercise ofoptions granted pursuant to the 1995 Plan. On April 26, 2001, ourstockholders increased the overall number of shares available for issuancepursuant to the plan to 825,000 shares of common stock. The 1995 Plan providedfor the issuance of both non-qualified and incentive stock options to ouremployees, officers, and employee-directors. The 1995 Plan expired by its termson March 21, 2005 and no options were available for future issuance after theexpiration.  At September 30, 2007,67,365 employee options have been exercised and employee options to purchase atotal of 351,164 shares of common stock are outstanding.  A total of 2,290,295 options have beengranted pursuant to the 1995 Plan, of which, 1,871,766 have been cancelled.

 

In 1995, we adopted the 1995 Non-Employee Director Stock Option Plan(the “1995 Non-Employee Director Plan”). The 1995 Non-Employee Director Plan provided for the issuance ofnon-qualified stock options to non-employee directors. The 1995 Non-EmployeeDirector Plan was amended in April 2002 to increase the number of sharesavailable for issuance to 65,000 from 40,000 shares. The 1995 Non-EmployeeDirector Plan expired by its terms on March 21, 2005 and no options wereavailable for future issuance after the expiration.  No options have been exercised under the 1995Non-Employee Director Plan.  Non-employeeoptions to purchase a total of 32,500 shares of common stock areoutstanding at September 30, 2007. A total of 62,500 options have beengranted to directors pursuant to the 1995 Non-Employee Director Plan, of which,30,000 have been cancelled.

 

                OnMarch 17, 2005, the Board approved the 2005 Stock Incentive Plan (the “2005Plan”), which was approved by the stockholders on June 14, 2005.  The 2005 Plan serves as a replacement for the1995 Non-Employee Director Plan and the 1995 Option Plan which expired by theirterms on March 21, 2005.  Theapproval of the 2005 Plan had no effect on the 1995 Plans or any optionsgranted pursuant to either plan.  Alloptions will continue with their existing terms and will be subject to the 1995Non-Employee Director Plan or the 1995 Plan, as applicable.  Further, the Company will not be able tore-issue any option which is cancelled or terminated under the 1995Non-Employee Director Plan or the 1995 Option Plan.  Originally, the 2005 Plan provided for theissuance of up to 750,000 shares of common stock upon exercise of optionsgranted pursuant to the 2005 Plan.  Thisamount was increased by an additional 750,000 shares as approved by the Boardon January 25, 2007 and the stockholders on May 30, 2007.  The 2005 Plan consists of three (3) separateequity incentive programs: the Discretionary Option Grant Program; the StockIssuance Program; and the Automatic Option Grant Program for non-employee Boardmembers.  Officers and employees,non-employee Board members and independent contractors are eligible to participatein the Discretionary Option Grant and Stock Issuance Programs.  Participation in the Automatic Option GrantProgram is limited to non-employee members of the Board.  Each non-employee Board member will receivean option grant for 10,000 shares of Common Stock upon initial election orappointment to the Board, provided that individual has not previously beenemployed by the Company in the preceding six (6) months.  In addition, on the date of each annualstockholders meeting, each Board member will automatically be granted an optionto purchase 5,000 shares of Common Stock, provided he or she has served as anon-employee Board member for at least six (6) months.  At September 30, 2007, no 2005 Plan optionshave been exercised and employee and non-employee Board member options topurchase a total of 882,500 shares of common stock are outstanding.  A total of 1,072,500 options have beengranted under the 2005 Plan, of which 190,000 have been cancelled and optionsfor 617,500 shares remain available for future grant.  No shares have been issued pursuant to theStock Issuance Program.

 

TheCompensation Committee of our Board of Directors determines for all employeeoptions, the term of each option, option exercise price within limits set forthin the plans, number of shares for which each option is granted and the rate atwhich each option is exercisable (generally ratably over one, three or fiveyears from grant date).  However, theexercise price of any incentive stock option may not be less than the fair marketvalue of the shares on the date granted (or less than 110% of the fair marketvalue in the case of optionees holding more than 10% of our voting stock of theCompany), and the term cannot exceed ten years (five years for incentive stockoptions granted to holders of more than 10% of our voting stock).

 

7

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The following table summarizes stock-basedcompensation expense under SFAS No. 123(R) for the three months and nine monthsended September 30, 2007 and September 30, 2006 (in thousands, except per sharedata) which was allocated as follows:

 
| ** **                                        | ** ** | **For Three Months Ended** | ** ** | **For Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| ** **                                        | ** ** | **September 30, 2007**     | ** ** | **September 30, 2006**    | ** ** | **September 30,  2007(1)** | ** ** | **September 30,  2006** | ** ** |
|                                              |       |                       |       |                      |       |   |   |   |   |
| Cost of revenue                                   |       | $                          | 1          |                      | $          | 1 |   | $ | — |   | $ | 24 |   |
| Research and development                          |       | 14                         |       | 15                        |       | 34 |   | 94 |   |
| Sales and marketing                               |       | 24                         |       | 16                        |       | 38 |   | 164 |   |
| General and administrative                        |       | 10                         |       | 7                         |       | 21 |   | 120 |   |
| Effect on net loss                                |       | $                          | 49         |                      | $          | 39 |   | $ | 93 |   | $ | 402 |   |
| Effect on basic and diluted loss per common share |       | $                          | (0.00      | )                         | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.06 | ) |

 

ValuationAssumptions

 

Thefair values of option awards were estimated at the date of grant using aBlack-Scholes option-pricing model with the following assumptions:

 
| ** **                             | ** ** | **For Three Months Ended  September 30, 2007** | ** ** | **For Three Months Ended  September 30, 2006** | ** **                  | **For Nine Months Ended  September 30, 2007** | ** ** | **For Nine Months  Ended  September 30, 2006** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|-----------------------------------------------------|-----------------------------|---------------------------------------------------------|------------|----------------------------------------------------------|------------|
|                                   |       |                                                     |       |                                                |                        |                                                    |       |                                                     |       |
| Weighted average grant date fair value |       | $                                                        | 0.30       |                                                | No Options Issued |                                                    | $          | 0.32                                                     |       | $ | 1.03 |   |
| Weighted average assumptions used:     |       |                                                     |       |                                                |                        |                                                    |       |                                                     |       |
| Expected dividend yield                |       | 0.0                                                      | %          | n/a                                                 |                        | 0.0                                                     | %          | 0.0                                                      | %          |
| Risk-free interest rate                |       | 4.9                                                      | %          | n/a                                                 |                        | 4.9                                                     | %          | 4.6                                                      | %          |
| Expected volatility                    |       | 103.6                                                    | %          | n/a                                                 |                        | 105.1                                                   | %          | 98.6                                                     | %          |
| Expected life (in years)               |       | 5.0                                                      |       | n/a                                                 |                        | 4.9                                                     |       | 5.0                                                      |       |
|                                        |            |                                                          |            |                                                     |                             |                                                         |            |                                                          |            |  |  |  |

 

 

TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options that have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becauseour employee stock options have characteristics significantly different fromthose of traded options, and because changes in the subjective inputassumptions can materially affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

 

Expectedvolatility is based on historical volatility and in part on impliedvolatility.  The expected term considersthe contractual term of the option as well as historical exercise andforfeiture behavior.  The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward.

 

8

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StockIncentive Plan Activity

 

                Stock option activity under theCompany’s various long-term incentive and director compensation plans duringthe nine months ended September 30, 2007, were as follows:

 
| ** **                        | ** ** | **Number of  Options  (in thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | ** **                             | ** ** | ** **                             | ** ** |
| Outstanding at December 31, 2006  |       | 1,086                                  |       | $                                      | 3.23       |   |
| Granted                           |       | 346                                    |       | 0.42                                   |       |
| Exercised                         |       | —                                 |       | —                                 |       |
| Cancelled                         |       |                                   |       |                                   |       |
| Forfeited                         |       | (125                                   | )          | 0.68                                   |       |
| Expired                           |       | (41                                    | )          | 3.83                                   |       |
|                              |       |                                   |       |                                   |       |
| Outstanding at September 30, 2007 |       | 1,266                                  |       | $                                      | 2.70       |   |

 

                Summarized information aboutoutstanding stock options as of September 30, 2007, that are fully vested andthose that are expected to vest in the future as well as stock options that arefully vested and currently exercisable, are as follows:

 
| **As of September 30, 2007**                 | ** ** | **Outstanding Stock**

**Options (Fully Vested and**

**Expected to Vest)*** | ** ** | **Options that are**

**Exercisable** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | ** **                                                                   | ** ** | ** **                            | ** ** |
| Number of outstanding options (in thousands) |       | 1,027                                                                        |       | 581                                   |       |
| Weighted average remaining contractual life  |       | 6.42                                                                         |       | 5.30                                  |       |
| Weighted average exercise price per share    |       | $                                                                            | 3.20       |                                  | $          | 5.23 |   |
| Intrinsic value (in thousands)               |       | $                                                                            | 13.4       |                                  | $          | — |   |

----

* Includes effects of expected forfeitures

 

 

                As of September 30, 2007, thetotal unrecognized compensation cost related to non-vested options not yetrecognized in the statement of operations totaled approximately $166 thousand(including estimated forfeitures) and the weighted average period over whichthese costs are expected to be recognized is 1.30 years.

 

5.     Net LossPer Share

 

Basic net loss per share is computed by dividing netloss attributable to common stockholders for the period by the weighted averagenumber of common shares outstanding for the period.  Diluted net loss per share is computed bydividing the net loss attributable to common stockholders by the weightedaverage number of common shares and common stock equivalents outstanding forthe period.  Our common stock equivalentsinclude all common stock issuable upon conversion of preferred stock and theexercise of outstanding options and warrants. The aggregate number of common stock equivalents excluded from thediluted loss per share calculation for the periods ended September 30, 2007 and2006 are 4,131,756 and 3,721,769, respectively. Our common stock equivalents are not included in the diluted loss pershare for the three and nine month periods ended September 30, 2007 and 2006,as they are antidilutive.

 

6.     NewAccounting Pronouncement

 

InJanuary 2007, we adopted the Financial Accounting Standards BoardInterpretation No. 48, “Accounting for Uncertainty in Income Taxes — AnInterpretation of FASB Statement No. 109” (FIN 48). This interpretationclarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements. FIN 48 requires companies to determine whetherit is “more likely than not” that a tax position will be sustained uponexamination by the appropriate taxing authorities before any part of thebenefit can be recorded in the financial statements. It also provides guidanceon the recognition, measurement and classification of income tax uncertainties,along with any related interest and penalties. We did not recognize anyadjustments to our financial statements as a result of our implementation ofFIN 48.

 

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7.     Commitmentsand Contingencies

 

We are subject to legal proceedings and claims thatarise in the ordinary course of business. We do not believe that the outcome of those matters will have a materialadverse affect on our consolidated financial position, operating results orcash flows.  However, there can be noassurance such legal proceedings will not have a material impact**.**

 

8.               Common Stock

 

                OnSeptember 26, 2007, we completed a private placement to our CEO for 1,190,476shares of our common stock for gross proceeds totaling $500,000.  On June 28, 2007, we completed a privateplacement to our CEO and CFO of 1,111,111 shares of our common stock for grossproceeds totaling $500,000.  On March 15,2007, we completed a private placement to our CEO and CFO of 925,926 shares ofour common stock for gross proceeds totaling $500,000.

 

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Item2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS

 

Forward Looking Statements

 

This Quarterly Report onForm 10-QSB, including, without limitation, the section entitled “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,”contains forward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.Such forward-looking statements are generally accompanied by words such as “estimate,”“expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or otherwords that convey uncertainty of future events or outcomes.  These statements relate to future events orto our future financial performance, and involve known and unknown risks,uncertainties and other factors that may cause our actual results, levels ofactivity, performance, or achievements to be materially different from anyfuture results, levels of activity, performance or achievements expressed orimplied by these forward-looking statements. Factors that may cause actualresults to differ materially from current expectations, which we describe inmore detail elsewhere in this Quarterly Report on Form 10-QSB under the heading“Factors That May Affect Future Results of Operations,” include, but are notlimited to:

•                  insufficient cash to operate our business and inability to meet ourliquidity requirements;

•                  loss of revenues due to the failure of our newer products to achievemarket acceptance;

•                  our need to generate substantially greater revenues from sales in orderto achieve profitability;

•                  concentration of our revenues from U.S. government entities and thepossibility of loss of one of these customers;

•                  unique risks associated with government customers;

•                  our dependence on sales made through indirect channels;

•                  the challenge of selling our products internationally;

•                  our dependence on equity financing provided primarily by our ChiefExecutive Officer in order to meet our cash flow requirements;

•                  the effect that payment of accrued dividends on our preferred stock hason our cash resources;

•                  substantial dilution upon the conversion or redemption of our preferredstock and exercise of outstanding warrants;

•                  the impact of conversion of preferred stock or exercise of warrants onthe price of our common stock;

•                  the ability of our preferred stockholders and lenders to hinderadditional financing; and

•                  the influence that our management and larger stockholders have overactions taken by the company.

                If one or more of these or other risks oruncertainties materialize, or if our underlying assumptions prove to beincorrect, actual results may vary significantly from what we projected. Theseforward-looking statements and other statements made elsewhere in this reportare made in reliance on the Private Securities Litigation Reform Act of1995.  Any forward-looking statement youread in this Quarterly Report on Form 10-QSB reflects our current views withrespect to future events and is subject to these and other risks, uncertaintiesand assumptions relating to our operations, results of operations, growthstrategy and liquidity. We assume no obligation to publicly update or revisethese forward-looking statements for any reason, or to update the reasonsactual results could differ materially from those anticipated in theseforward-looking statements, even if new information becomes available in thefuture.  The section below entitled “FactorsThat May Affect Future Results of Operations” sets forth and incorporates byreference certain factors that could cause actual future results of the Companyto differ materially from these statements.

Critical Accounting Policies and Estimates

 

Management’s discussion and analysis of financialcondition and results of operations are based upon our unaudited condensedconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States.  The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities.  On anon-going basis, we evaluate our estimates, including those related to productreturns, bad debts, inventories, income taxes, warranty obligations,restructuring, maintenance contracts and contingencies.  We base our estimates on historicalexperience and on various other assumptions that we believe are reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believe the following critical accounting policiesaffect our more significant judgments and estimates used in the preparation ofour unaudited condensed consolidated financial statements.

 

 

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*Revenue Recognition*

 

Wegenerally recognize product revenue upon shipment of product. We accrue forestimated warranty costs and sales returns at the time of shipment based on ourexperience. Revenue from maintenance contracts is deferred and recognized overthe contractual period the services are performed, generally one year.  There is a risk that technical issues on newproducts could result in unexpected warranty costs and returns.  However, as we migrate to more of asoftware-based business model, the warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  To the extent that our warranty costs exceedour expectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriatereserve percentage.  However, to date,warranty costs and sales returns have not been material.  Historically, our estimates for these itemshave not differed materially from actual results.  Significant or subjective estimatesassociated with our revenue recognition policy include our estimate of warrantycost and sales returns.

 

Werecognize software revenue from the licensing of our software products inaccordance with Statement of Position (“SOP”) No. 97-2 “Software RevenueRecognition”, SOP 98-9 “Modification of 97-2, Software Revenue Recognition,with respect to certain transactions” and Staff Accounting Bulletin (“SAB”) No.104, “Revenue Recognition” whereby revenue from the licensing of our productsis not recognized until all four of the following criteria have been met:i) execution of a written agreement; ii) delivery of the product hasoccurred; iii) the fee is fixed and determinable; andiv) collectability is probable. Bundled hardware and perpetual softwareproduct sales are recognized at time of delivery, as our licenses are not soldon a subscription basis.  In the case ofmultiple product and service sales, we perform a Vendor Specific ObjectiveEvidence analysis to appropriately determine the amount of revenue derived fromeach deliverable.  If our licensestrategy changes and we begin to offer licenses on a subscription basis, wewould perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscriptionperiod.  Market values are easilyobtained for all of our product offerings, as we have historical sales informationon our product offerings.  We defer andrecognize maintenance and support revenue over the term of the contract period,which is generally one year.

 

Wehave signed distribution agreements with distributors in the United States,Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that areslow moving or have been discontinued by us. Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors and related gross profits aredeferred until the distributors resell the merchandise. However, since we havelegally sold the inventory to the distributor and we no longer have care,custody or control over the inventory, we recognize the trade accountsreceivable and reduce inventory related to the sale at the time of shipment tothe distributor. Revenue, offset by deferred cost of sales, is included indeferred revenue in the accompanying financial statements.  Since the net balance in deferred revenuerepresents the sales price less the cost of the product maintained by thedistributors, the deferred costs of these products are included in ourobsolescence and slow-moving analysis and are written down according to theirestimated current value.  Thistransaction effectively recognizes expense for the write-down, if any, andincreases the net liability in the deferred revenue account.

 

Wegenerally recognize service revenue upon delivery of the contractedservice.  Service revenue, primarilyincluding maintenance, training and installation, are recognized upon deliveryof the service and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

 

*Allowance for Doubtful Accounts and Returns*

 

Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. Our receivables areuncollaterized and we expect to continue this policy in the future.  If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, additional allowances may be required.  Historically, our estimates for sales returnsand doubtful accounts have not differed materially from actual results.

 

*Inventory*

 

Wewrite down our inventory for estimated obsolescence or unmarketable inventoryequal to the difference between the cost of inventory and the estimated marketvalue based upon assumptions about future demand and market conditions. Ifactual market conditions are less favorable than those projected by management,additional inventory write-downs may be required.   Historically, our estimates for inventoryobsolescence have not differed materially from actual results.

 

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Results of Operations

 

The following table sets forth, for the periodsindicated, certain financial data as a percentage of net revenues. Theperiod-to-period comparison of financial results is not necessarily indicativeof future results.

 
| ** **                                       | ** ** | **Three Months Ended**      | ** ** | **Nine Months Ended**       | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| Net product revenue                              |       | 81.5                        | %          | 84.4                        | %          | 82.2 | % | 74.9 | % |
| Net customer support and maintenance revenue     |       | 18.5                        |       | 15.6                        |       | 17.8 |   | 25.1 |   |
| Total revenue                                    |       | 100.0                       |       | 100.0                       |       | 100.0 |   | 100.0 |   |
| Cost of product revenue                          |       | 38.6                        |       | 43.5                        |       | 37.5 |   | 38.0 |   |
| Cost of customer support and maintenance revenue |       | 1.6                         |       | 1.3                         |       | 1.8 |   | 4.8 |   |
| Total cost of revenue                            |       | 40.3                        |       | 44.8                        |       | 39.3 |   | 42.8 |   |
| Gross profit                                     |       | 59.7                        |       | 55.2                        |       | 60.7 |   | 57.2 |   |
| Operating expenses:                              |       |                        |       |                        |       |   |   |   |   |
| Sales and marketing                              |       | 54.4                        |       | 32.4                        |       | 50.4 |   | 58.7 |   |
| Research and development                         |       | 39.0                        |       | 15.7                        |       | 38.8 |   | 44.3 |   |
| General and administrative                       |       | 27.7                        |       | 17.6                        |       | 24.2 |   | 27.4 |   |
| Operating loss                                   |       | (61.3                       | )          | (10.5                       | )          | (52.7 | ) | (73.3 | ) |
|                                             |       |                        |       |                        |       |   |   |   |   |
| Other income (expense), net                      |       | —                      |       | —                      |       | — |   | (1.7 | ) |
| Interest income(expense), net                    |       | 0.1                         |       | 0.1                         |       | 0.1 |   | 1.1 |   |
| Loss before income tax provision                 |       | (61.2                       | )          | (10.4                       | )          | (52.6 | ) | (73.9 | ) |
|                                             |       |                        |       |                        |       |   |   |   |   |
| Income tax provision                             |       | —                      |       | —                      |       | — |   | — |   |
|                                             |       |                        |       |                        |       |   |   |   |   |
| Net loss                                         |       | (61.2                       | )%         | (10.4                       | )%         | (52.6 | )% | (73.9 | )% |
| Preferred stock dividends accrued                |       | (4.8                        | )          | (2.5                        | )          | (4.3 | ) | (3.5 | ) |
| Beneficial conversion feature on preferred stock |       | —                      |       | —                      |       | — |   | — |   |
|                                             |       |                        |       |                        |       |   |   |   |   |
| Net loss attributable to common stockholders     |       | (66.0                       | )%         | (12.9                       | )%         | (56.9 | )% | (77.3 | )% |

 

 
| ** **          | ** ** | **Three Months Ended**      | ** ** | **Nine Months Ended**       | ** ** |
|---------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **          | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| Domestic revenues   |       | 95.0                        | %          | 93.0                        | %          | 92.8 | % | 89.5 | % |
| Export revenues to: |       |                        |       |                        |       |   |   |   |   |
| Europe              |       | 4.1                         |       | 5.5                         |       | 6.3 |   | 8.1 |   |
| Canada              |       | 0.1                         |       | 1.0                         |       | 0.1 |   | 1.3 |   |
| Asia                |       | 0.6                         |       | 0.4                         |       | 0.7 |   | 1.0 |   |
| Latin America       |       | 0.2                         |       | 0.1                         |       | 0.1 |   | 0.1 |   |
|                |       |                        |       |                        |       |   |   |   |   |
| Net revenues        |       | 100.0                       | %          | 100.0                       | %          | 100.0 | % | 100.0 | % |

 

**Net Revenues**.  Net revenuesfor the quarter and nine months ended September 30, 2007 were $0.9 million and$3.0 million, respectively, compared to $1.7 million and $3.8 million for thesame periods in 2006.  Product revenuesdecreased $0.7 million and $0.4 million, respectively, for the quarter and ninemonths ended September 30, 2007 compared to the same periods in 2006.  Our revenue decline was due to the transitionof our sales focus from the intrusion detection/prevention products to theregulated information compliance products. Customer support and maintenance revenue for the quarter and nine monthsdecreased $0.1 million and $0.4 million, respectively compared to the sameperiods in 2006.  This decrease wasmainly due to a decrease in net product revenue in the corresponding periods.

 

**Concentration of Revenues**. Revenues from sales to various U.S. government entities totaled $0.7million, or 75.4% of revenues, for the quarter ended September 30, 2007compared to $1.3 million, or 73.8% of revenues, for the same period in2006.  Revenues from sales to variousU.S. government entities totaled $2.3 million, or 75.3% of revenues, for thenine months ended September 30, 2007 compared to $2.7 million, or 71.8% ofrevenues, for the same period in 2006. Although we expect our concentration of revenues to vary among customersin future quarters depending upon the timing of certain sales, we anticipatethat sales to government customers will continue to account for a significantportion of our revenues in future quarters. Sales to the 

 

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government present risks in addition to those involvedin sales to commercial customers which could adversely affect our revenues,including potential disruption to appropriation and spending patterns and thegovernment’s reservation of the right to cancel contracts and purchase ordersfor its convenience.  Although we do notbelieve that that any of our revenues with government customers are subject torenegotiation, a large number of cancelled or renegotiated government orderscould have a material adverse effect on our financial results.  Currently, we are not aware of any proposedcancellation or renegotiation of any of our existing arrangements withgovernment entities and, historically, government entities have not cancelledor renegotiated orders which had a material adverse effect on our business.

 

**Gross Profit**.  Gross profitwas $0.5 million or 59.7% of net revenues for the quarter ended September 30,2007, compared to $1.0 million or 55.2% of net revenues for the quarter endedSeptember 30, 2006.  Gross profit was$1.8 million or 60.7% of net revenues for the nine months ended September 30,2007, compared to $2.2 million or 57.2% of net revenues for the nine monthsended September 30, 2006.  Gross profiton product revenues for the quarter and nine months ended September 30, trendedfrom 48.4% and 49.3%, respectively, in 2006 to 52.6% and 55.4%, respectively,in 2007 due to the transition to our more profitable software-basedproducts.  Gross profit on customersupport and maintenance revenues for the quarter and nine months endedSeptember 30, trended from 91.5% and 80.8%, respectively, in 2006 to 91.2% and89.8%, respectively, in 2007.  Gross profit as a percentage of netrevenues is impacted by several factors, including shifts in product mix,changes in channels of distribution, revenue volume, pricing strategies, andfluctuations in revenues of integrated third-party products.

 

**Sales and Marketing**.  Sales andmarketing expenses decreased to $0.5 million for the quarter ended September 30,2007, compared to $0.6 million for the quarter ended September 30, 2006. Salesand marketing expenses decreased to $1.5 million for the nine months endedSeptember 30, 2007, compared to $2.2 million for the nine months endedSeptember 30, 2006 primarily due to a planned reduction in sales personnel andrelated expenses.  Sales and marketingexpenses may vary in the future. However, we believe that these costs will remain relatively constantthrough the end of 2007.

 

**Research and Development**.  Research anddevelopment expenses were $0.4 million for the quarter ended September 30, 2007compared to $0.3 million for the quarter ended September 30, 2006. Research anddevelopment expenses decreased to $1.2 million for the nine months endedSeptember 30, 2007, compared to $1.7 million for the nine months endedSeptember 30, 2006.  Research and developmentcosts are expensed in the period incurred. Research and development expenses remained relatively flat in the threemonths ended September 30, 2007, compared to the same period in 2006 anddecreased in the nine months ended September 30, 2007, compared to the sameperiod in 2006 primarily due to shifts from R&D expenses to cost of salesin relation to engineering contract jobs. Research and development expenses may vary in the future; however, webelieve that these costs will remain relatively constant through the end of2007.

 

**General and Administrative**.  General andadministrative expenses were $0.3 million for the quarter ended September 30,2007 compared to $0.3 million for the quarter ended September 30, 2006.  General and administrative expenses decreasedto $0.7 million for the nine months ended September 30, 2007, compared to $1.0million for the nine months ended September 30, 2006 due in part to decreasesin stock-based compensation expense and administrative overhead expenses.  It is expectedthat general and administrative expenses will remain relatively constantthroughout the remainder of 2007, as no further cost reductions areanticipated.

 

**Interest**.  Net interestincome decreased to $1 thousand for the quarter ended September 30, 2007compared to $2 thousand interest income for the same period in 2006.  Net interest income decreased to $2 thousandfor the nine months ended September 30, 2007 compared to $43 thousand for thesame period in 2006.  The decrease ininterest income was primarily due to a decrease of cash and short-terminvestment balances when compared to the prior year and an increase in interestexpense related to the line of credit.  Netinterest income may vary in the future based on our cash flow and rate ofreturn on investments.

 

Liquidity and Capital Resources

 

Our principal source of liquidity at September 30,2007 is approximately $0.9 million of cash and cash equivalents.  At September 30, 2007 working capital was$0.4 million compared to $0.2 million at September 30, 2006.

 

Cash used in operations forthe nine months ended September 30, 2007 was $1.2 million, primarily due to anet loss of $1.6 million and the following uses of cash: a $305 thousanddecrease in accounts payable and accrued expenses, a $19 thousand increase ininventories, a $16 thousand reduction in deferred revenue and a $14 thousandreduction in the provision for doubtful accounts.  This was partially offset by the followingsources of cash and non-cash items: a $451 thousand decrease in accountsreceivable, a $117 thousand decrease in prepaid expenses and other assets, $93thousand in stock-based compensation and $45 thousand in depreciation expense.  Cash used in operations for the nine monthsended September 30, 2006 was $2.9 million, primarily due to a net loss of $2.8million and the following uses of cash: a $465 thousand increase in accountsreceivable, a $209 thousand decrease in accounts payable and accrued expenses,a $166 thousand reduction in deferred revenue and a $13 thousand reduction inthe provision for doubtful accounts. This was partially offset the following sources of cash and non-cashitems: a $134 thousand decrease in inventories, a $128 thousand decrease inprepaid expenses and other assets, $402 thousand in stock-based compensationand $80 thousand in depreciation expense. Future fluctuations in inventory balances, accounts receivable andaccounts payable will be dependent upon several factors, 

 

14

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including, but not limitedto, quarterly sales, our strategy in building inventory in advance of receivingorders from customers, and the accuracy of our forecasts of product demand andcomponent requirements.

 

There was $39 thousand ofcash used in investing activities in the nine months ended September 30, 2007for net purchases of property and equipment, compared to $500 thousand providedby investing activities in the nine months ended September 30, 2006 primarilyrelated to the maturities of short-term investments offset slightly by netpurchases of property and equipment.

 

Cash provided by financing activities in the ninemonths ended September 30, 2007 was $1.3 million, primarily consisting of theproceeds from the issuance of common stock of $1.5 million, partially offset bypayment of dividends on preferred stock of $115 thousand and a net reduction inthe line of credit of $100 thousand, compared to cash used in financingactivities in the nine months ended September 30, 2006 was $132 thousand,primarily consisting of the payment of dividends on preferred stock.

 

At September 30, 2007,the Company did not have any material commitments for capital expenditures.

 

During the three monthsended September 30, 2007, the Company funded its operations through the use ofcash and cash equivalents.

 

OnSeptember 26, 2007, we completed a private placement of 1,190,476 shares of ourCommon Stock for gross proceeds of $500,000.

 

OnMarch 29, 2006, we established a $1,000,000 line of credit with Silicon ValleyBank.  The line of credit was renewed onMarch 29, 2007.  Under the terms of thisagreement, we may borrow an amount equal up to 80% of eligible accountsreceivable balances.  In addition, we mayobtain inventory advances equal to 35% of finished good inventory, capped atthe lesser of the inventory availability, $300,000 or 35% of our totalborrowing base.  If our credit lineincreases to $2,000,000, inventory advances will be capped at the lesser of theinventory availability, $600,000 or 35% of our borrowing base.  Amounts we borrow under the credit lineaccrue interest at an annual rate of prime plus 1% and are secured by a lien onall of our assets.  Accrued interest onall outstanding amounts is payable monthly in arrears and all outstandingprincipal and accrued but unpaid interest on the amounts we borrow are due onMarch 28, 2008.  Our ability to receiveadvances under this credit line will increase if we generate additionalreceivables and inventory.  We have acurrent balance due under this credit line of $100,000 at September 30,2007.  Also, assuming receivables andinventory equal to the $425,000 of net accounts receivable and the $207,000 offinished goods inventory we had at September 30, 2007, we had approximately$100,000 additional funds available under our credit line at September 30,2007.

 

Net operating losses andoperating cash outflows may continue through the fourth quarter of 2007 andpossibly into fiscal year 2008.  The sufficiencyof our cash resources may depend to a certain extent on general economic,financial, competitive or other factors beyond our control.  In addition, we are obligated to make payments ofaccrued dividends on all our outstanding shares of preferred stock that willreduce our available cash resources.   Ofthe $0.9 million in cash and cash equivalents at September 30, 2007, $0.5million was derived from a private investment by our Chief Executive Officerwhich closed on September 26, 2007.   Inaddition, we received an additional $0.5 million in each of our last twoquarters as a result of private investments by our Chief Executive Officer andChief Financial Officers. This $1.5 million in equity financing has had theeffect of significantly diluting our existing shareholders, as we issued3,227,513 shares of common stock in exchange for this investment.  As of September 30, 2007 we had approximately$100 thousand additional funds available under our existing credit line.  Based on projections forincreased revenues for the next twelve months and the closing of the $0.5million private placement on September 26, 2007, we believe that our availablecash resources will provide sufficient cash resources to finance our operationsand expected capital expenditures over the next twelve month period.  If we do not significantly increase our revenues tomeet our projections or obtain additional financing within the next threemonths, we will likely be unable to implement our business plan, fund ourliquidity needs or even continue our operations. Any equity or debt financings,if available at all, may be on terms which are not favorable to us and, in thecase of equity financings, most likely will result in dilution to ourstockholders.

 

We may explore the possible acquisitions ofbusinesses, products and technologies that are complementary to our existingbusiness.  We are continuing to identifyand prioritize additional security technologies, which we may wish to develop,either internally or through the licensing, or acquisition of products fromthird parties.  While we may engage fromtime to time in discussions with respect to potential acquisitions, there canbe no assurances that any such acquisitions will be made or that we will beable to successfully integrate any acquired business.  In order to finance such acquisitions andworking capital it may be necessary for us to raise additional funds throughpublic or private financings.  Any equityor debt financings, if available at all, may be on terms, which are not favorableto us and, in the case of equity financings, may result in dilution to ourstockholders.

 

Off-Balance Sheet Arrangements.

 

As of September 30, 2007, we did not have anysignificant off-balance sheet arrangements, as defined by Item 303(c)(2) of RegulationS-B.

 

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Factors That May Affect Future Results of Operations 

 

Numerous factors may affect our business and futureresults of operations.  These factorsinclude current economic and market conditions, the effect of military actionson government and corporate spending on information security products, spendingpatterns of, and appropriations to, U.S. government departments, technologicalchanges, competition and market acceptance, acquisitions, product transitions,timing of orders, manufacturing and suppliers, reliance on outsourcing vendorsand other partners, intellectual property and licenses, third-party products,dependence on government customers, international operations, intellectualproperty issues, liquidity and cash resources and effects of restructuringplans and cost reductions.  Thediscussion below addresses some of these and other factors.  For a more thorough discussion of these andother factors that may affect our business and future results, see thediscussion under the caption “Factors That May Affect Future Results ofOperations” in our Annual Report on Form

10-KSB for the year ended December 31, 2006.

 

***Unless we significantly increaserevenues or obtain additional financing within the next three months, we arenot likely to have sufficient cash to operate our business and may not be ableto maintain our liquidity requirements.***

 

As of September 30, 2007,we had cash and cash equivalents of approximately $0.9 million; however, we havecompleted $0.5 million in equity financing in each of the last three quarters,which has permitted us to fund operations for 2007.  Net operating losses and operating cashoutflows may continue through the fourth quarter of 2007 and possibly intofiscal year 2008.  In addition, we areobligated to make payments of accrued dividends on all our outstanding sharesof preferred stock that will reduce our available cash resources for the fourthquarter of 2007.  As of September 30,2007 we had approximately $100 thousand available under our existing creditlines.  If we do not significantlyincrease our revenues or obtain additional financing within the next threemonths, we will likely be unable to implement our business plan, fund ourliquidity needs or even continue our operations. Any equity or debt financings,if available at all, may be on terms which are not favorable to us and, in thecase of equity financings, most likely will result in dilution to ourstockholders.

 

***Our recent equity financings havehad the effect of significantly diluting our existing shareholders, and futurerounds of equity financing will likely have a similar impact.***

 

In order to fund ouroperations, our Chief Executive Officer and Chief Financial Officer haveinvested an aggregate amount of $1.5 million in fiscal year 2007, in exchangefor which we have issued an aggregate of 3,227,513 shares of our common stock,representing approximately 28% of our issued and outstanding common stock.  The issuance of this stock has significantlydiluted our existing shareholders.  If weare unable to significantly increase our revenues in the near term, we arelikely to need additional financing to continue operations.  If this financing involves the issuance ofadditional shares of our common stock, our shareholders will experience furtherdilution.

 

***Our revenues have declined inconnection with a shift in focus from SecureNet products to ComplianceCommander and TraceCop products.   If ournewer products do not achieve market acceptance, our revenues will continue tosuffer.***

 

We have transitioned oursales strategy focus from SecureNet to Compliance Commander and TraceCop.  During this transition, sales of our newerproducts have not offset the losses in sales associated with our older products. As a result, our net revenues declinedfrom $6.0 million in 2005 to $5.2 million in 2006 and decreased from $3.8million for the first three quarters of 2006 compared to $1.7 million for thefirst three quarters of 2007.  We canprovide no assurances that sales of our newer products will ever offset thelosses in sales of older products or generate sufficient revenues to sustainour business.

 

Our new network securityproducts, regulated information compliance systems and entity identificationproducts have only been in the market place for a limited period of time andmay have longer sales cycles than our previous products.  Accordingly, we may not achieve themeaningful revenue growth needed to sustain operations.  If we are unable to recognize revenues due tolonger sales cycles or other problems, our results of operations will beadversely affected, perhaps materially.

 

We have not yet receivedbroad market acceptance for our newer products. We cannot assure you that our present or future products will achievemarket acceptance on a sustained basis. In order to achieve market acceptance and achieve future revenue growth,we must introduce complementary security products, incorporate new technologiesinto our existing product lines and design, develop and successfullycommercialize higher performance products in a timely manner.  We cannot assure you that we will be able tooffer new or complementary products that gain market acceptance quickly enoughto avoid decreased revenues during current or future product introductions ortransitions.

 

***We had a net loss of $0.6 millionfor the quarter ended September 30, 2007 and an accumulated deficit of $56.7million at September 30, 2007.  As aresult, we must generate substantially greater revenues from sales in order toachieve profitability.***

 

We incurred significantoperating losses for the quarter ended September 30, 2007 and have incurredoperating losses in previous quarters. We need to generate and sustain substantially greater revenues from thesales of our products if we are to achieve 

 

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profitability. If we are unable to achieve these greater revenues, our losses willcontinue for the near term and possibly longer, and we may never achieve orsustain profitability or generate positive cash flow from operations.

 

***Our management andlarger stockholders exercise significant control over our company and have theability to approve or take actions that may be adverse to your interests.***

 

As of October 31, 2007,our executive officers, directors and preferred stockholders beneficially ownapproximately 47.9% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.  Further, the Company contemplates thepossible issuance of shares of our Common Stock or of securities exercisable orconvertible into shares of our Common Stock in connection with future privateplacement stock offerings funded by our Chief Executive Officer or other members of management.  Any such issuance may increase the percentageof stock our Chief Executive Officer and our management group beneficiallyholds.

 

 

***A large percentageof our revenues are received from U.S. government entities, and the loss of oneof these customers could reduce our revenues and materially harm our businessand prospects.***

 

                A large percentage of our revenues result from salesto U.S. government entities.  If we were to loseone or more of these key relationships, our revenues could decline and ourbusiness and prospects may be materially harmed. We expect that even if we aresuccessful in developing relationships with non-governmental customers, ourrevenues will continue to be concentrated among government entities. For thequarter ended September 30, 2007, sales to U.S. government entitiescollectively accounted for 75.4% of our total net revenues.  For the years ended December 31, 2004, 2005****and 2006, sales to U.S. governmententities collectively accounted for 53.6%, 70.7% and 73.6% of our total netrevenues, respectively. The loss of any of these key relationships may send anegative message to other U.S. government entities or non-governmentalcustomersconcerning our product offering.  Wecannot assure you that U.S. government entities will be customers of ours in future periodsor that we will be able to diversify our customer portfolio to adequatelymitigate the risk of loss of any of these customers.

 

***Governmentcustomers involve unique risks, which could adversely impact our revenues.***

 

We expect to continue toderive a substantial portion of our revenues from U.S. government customers inthe future.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customers,including potential disruption due to appropriation and spending patterns,delays in approving a federal budget and the government’s right to cancelcontracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, directly and indirectly may affect thequantity and allocation of expenditures by federal departments.  In addition, obtaining government contractsmay involve long purchase and payment cycles, competitive bidding,qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintains its own rules and regulations withwhich we must comply and which can vary significantly among departments.  As a result, cutbacks or re-allocations inthe federal budget or losses of government sales due to other factors couldhave a material adverse effect on our revenues and operating results.

 

***We are highly dependent on salesmade through indirect channels, the loss of which would materially adverselyaffect our operations.***

 

                Forthe years ended December 31, 2004, 2005 and 2006, we derived 36.9%, 36.2%and 17.3% of our revenues from sales through indirect sales channels, such asdistributors, value-added resellers, system integrators, original equipmentmanufacturers and managed service providers. We derived 24.2% of our revenues in the third quarter of 2007 from such saleschannels.  We must expand our salesthrough these indirect channels in order to increase our revenues.  We cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

***Our ability to sellour products internationally is subject to certain risks, which could harm ourbusiness.***

 

Revenues from foreigncustomers for the fiscal years ended December 31, 2004, 2005 and 2006 accountedfor approximately 19.2%, 10.7% and 9.4%, respectively, of our revenues.  Foreign revenues in the third quarter 2007were 5.0% of revenues.  We expect salesto foreign customers to continue to represent a significant portion of ourrevenues in the future.  Ourinternational operations are subject to many inherent risks that may adverselyaffect our business, financial condition and operating results, including:

•                  political, social and economicinstability;

 

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•                  trade restrictions;

•                  increases in duty rates and otherpotentially adverse tax consequences;

•                  exposure to different legal standards,particularly with respect to the protection of intellectual property;

•                  burdens of complying with a variety offoreign laws;

•                  unexpected changes in regulatoryrequirements;

•                  import and export license requirementsand restrictions of the United States and each other country where we operate;

•                  fluctuations in currency exchange rates;and

•                  changes in local purchasing practices, including seasonal fluctuationsin demand.

 

                Anyinterruptions or declines in our international sales would result in asignificant adverse impact on our results of operations and business.

 

***The payment ofaccrued dividends on our preferred stock may strain our cash resources.***

 

On March 25, 2004, wecompleted a $5,000,000 private placement pursuant to which we issued 1,000,000shares of our 5% Convertible Preferred Stock (the “Series 1 Preferred Stock”)and warrants to acquire 556,619 shares of our common stock.  The conversion price for the Series 1Preferred Stock and the exercise price of the warrants is $3.144 pershare.  We also issued our placementagent a warrant for 64,408 shares of our common stock at an exercise price of$3.144 per share.  As of October 31,2007, there were 259,696 shares of the Series 1 Preferred Stock outstanding,representing approximately 413,003 shares of common stock upon conversion, andwarrants to purchase 621,027 shares of common stock outstanding.

 

On March 28, 2005, wecompleted a $2,663,000 private placement pursuant to which we issued 1,065,200shares of our Series 2 5% Convertible Preferred Stock (the “Series 2 PreferredStock”) and warrants to acquire 532,600 shares of our common stock.  We also issued two affiliates of ourplacement agent warrants to purchase an aggregate of 60,390 shares of commonstock.  The conversion price for theSeries 2 Preferred Stock is $2.50 per share and the exercise price of thewarrants is $2.77 per share.  As ofOctober 31, 2007, there were 460,000 shares of the Series 2 Preferred Stockoutstanding, representing 460,000 shares of common stock upon conversion, andwarrants to purchase 592,990 shares of common stock outstanding.

 

On December 2, 2005, wecompleted a $1,230,843 private placement pursuant to which we issued 564,607shares of our Series 3 5% preferred stock (the “Series 3 Preferred Stock”) and warrants to acquire 282,306 sharesof our common stock.  We also issued twoaffiliates of our placement agent warrants to purchase an aggregate of 27,531shares of common stock.  The conversionprice of the Series 3 Preferred Stock is $2.18 per share and the exercise priceof the warrants is $2.58 per share.  Asof October 31, 2007, there were 468,735 shares of Series 3 Preferred Stockoutstanding, representing 468,735 shares of common stock upon conversion, andwarrants to purchase 309,837 shares of common stock outstanding.

 

                Duringthe fiscal year ended December 31, 2006, we paid $66,000 in dividends to theholders of our 5% Preferred Stock, $74,000 in dividends to the holders of ourSeries 2 5% Preferred Stock and $53,000 in dividends to the holders of ourSeries 3 5% Preferred Stock.  During thethree quarters ended on September 30, 2007, we paid $43,000 in dividends to theholders of our 5% Preferred Stock, $38,000 in dividends to the holders of ourSeries 2 5% Preferred Stock and $34,000 in dividends to the holders of ourSeries 3 5% Preferred Stock.  AtSeptember 30, 2007, we have dividends accrued of $32,551 related to our 5%Preferred Stock, $4,726 related to our Series 2 5% Preferred Stock and$4,199 related to our Series 3 5% Preferred Stock.

 

Delaware law providesthat we may only pay dividends out of our capital surplus or, if no surplus isavailable, out of our net profits for the fiscal year the dividend is declaredand/or the preceding fiscal year.  Wehave not had net profits for the last two fiscal years ended as of December 31,2006.  However, we did have sufficientcapital surplus, defined as the amount by which our net assets exceed ourstated capital, based on par value of our outstanding shares as provided byDelaware law.  We cannot assure you thatour net assets will continue to exceed our stated capital or that we will havenet profits in order to pay these dividends in the future.  These dividends continue to accrue on all ouroutstanding shares of preferred stock, regardless of whether we are legallyable to pay them.  The accrual of thesedividends may adversely affect our operating results.  Moreover, the payment of these dividends couldstrain our available cash resources, which could adversely affect our abilityto operate or grow our business.

 

                If we are unable to pay dividends on our preferredstock, we could be required to redeem the outstanding shares of Series 2Preferred Stock and Series 3 Preferred Stock for shares of our common stockissued at a price equal to 75% of the average of the volume weighted averageprice of our common stock for the ten days ending on the day immediatelypreceding an election to redeem, 

 

 

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subject, in the case ofthe Series 3 Preferred Stock, to a floor of $0.87.  As a result, the issuance or potentialissuance of these additional shares of common stock could cause our stock priceto decline.  Furthermore, our inabilityto pay dividends could adversely affect our ability to raise equity financingin the future if required.

 

***Youwill experience substantial dilution upon the conversion or redemption of theshares of preferred stock and the exercise of warrants that we issued in ourrecent private placements or in the event we raise additional funds through theissuance of new shares of our common stock or securities convertible orexercisable into shares of common stock.***

 

On October 31, 2007, wehad 11,523,726 shares of common stock outstanding.  Upon conversion of all outstanding shares ofour preferred stock and exercise of the warrants, we would have 14,383,318shares of common stock outstanding, an increase of approximately 24.9% in thenumber of shares of our common stock outstanding.

 

                Further,the occurrence of certain events entitles holders of our Series 2 PreferredStock and Series 3 Preferred Stock to require us to redeem their shares for acertain number of shares of our common stock. Assuming (i) we have paid all liquidated damages and other amounts tothe holders, (ii) incurred accrued but unpaid dividends on October 31, 2007 of$17,600, (iii) a volume weighted average price of $0.38, which was the ten-dayvolume weighted average closing price of our common stock on October 31, 2007,and (iv) our 11,523,726 shares of common stock outstanding on October 31, 2007,upon exercise of their redemption right by the holders of the Series 3Preferred Stock and the Series 2 Preferred Stock, we would be obligated toissue approximately 8,919,053 shares of our common stock.  This would represent an increase ofapproximately 77.4% in the number of shares of our common stock as of October31, 2007.

 

                Inaddition, management may issue additional shares of common stock or securitiesexercisable or convertible into shares of common stock in order to finance theCompany’s continuing operations.  Anyfuture issuances of such securities would have additional dilutive effects onthe existing holders of our Common Stock.

 

***The conversion of preferred stockor exercise of warrants we issued in the private placements may cause the priceof our common stock to decline.***

 

The holders of the sharesof our 5% Preferred Stock and warrants we issued in connection with the sale ofour 5% Preferred Stock may convert their shares of preferred stock and exercisetheir warrants and sell the underlying shares of common stock.  As of October 31, 2007, 740,304 shares of our5% Preferred Stock had converted into 1,177,327 shares of common stock.

 

The holders of the sharesof Series 2 5% Preferred Stock and warrants we issued in connection with thesale of our Series 2 Preferred Stock may convert their shares of preferredstock and exercise their warrants and sell the underlying shares of commonstock.  As of October 31, 2007, 605,200shares of Series 2 Preferred Stock had converted into 605,200 shares of commonstock.

 

The holders of the sharesof Series 3 5% Preferred Stock and warrants we issued in connection with thesale of our Series 3 Preferred Stock, may convert their shares of Series 3Preferred Stock and exercise their warrants and sell the underlying shares ofcommon stock pursuant to an effective registration statement we filed with theCommission on April 26, 2007.  As ofOctober 31, 2007, 95,872 shares of Series 3 Preferred Stock had converted into95,872 shares of common stock.

 

For the four weeks endedon October 26, 2007, the average daily trading volume of our common stock onThe OTCBB was 8,122 shares. Consequently, if holders of preferred stock or warrants elect to converttheir remaining shares or exercise their warrants and sell a material amount oftheir underlying shares of common stock on the open market, the increase inselling activity could cause a decline in the market price of our commonstock.  Furthermore, these sales, or thepotential for these sales, could encourage short sales, causing additionaldownward pressure on the market price of our common stock.

 

***Certain rights of the holders ofour preferred stock and the terms of our secured credit line may hinder ourability to raise additional financing.***

 

Under the terms of ourpreferred stock instruments, we cannot issue shares of capital stock withrights senior to those of our existing 5% Preferred Stock, Series 2 5%Preferred Stock or Series 3 5% Preferred Stock without the approval of at leasta majority of the holders of our 5% Preferred Stock, all of the holders of ourSeries 2 5% Preferred Stock, and holders of at least 75% of our Series 3 5%Preferred Stock voting or acting as separate classes.  We also cannot incur certain indebtednesswithout the approval of at least a majority of the holders of our PreferredStock.  Furthermore, the terms of oursecured credit line with Silicon Valley Bank include covenants which restrictour ability to incur additional debt and pay certain dividends.  The combination of these provisions couldhinder or delay our ability to raise additional debt or equity financing.

 

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***Our failure torealize the expected benefits of our recent restructuring efforts couldadversely affect our operating results.***

 

Since we beganrestructuring in 2002, we have incurred approximately $1.1 million inrestructuring charges, severance, and related expenses. We have alsoimplemented other strategic initiatives, such as reductions in our work forceand facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

 

***We resemble a developmental stagecompany and our business strategy may not be successful.***

 

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, we sold ourlocal area networking assets and related networking divisions.  We now depend exclusively on revenuesgenerated from the sale of our network security products, which have receivedlimited market acceptance.  We have alsointroduced our regulated information compliance systems, entity identificationproducts and spyware products, and the market for these products has only begunto emerge.  We can provide no assurancesthat our newly introduced products will ever achieve widespread marketacceptance or that an adequate market for these products will ever emerge.  Consequently, we resemble a developmental stagecompany and will face the following inherent risks and uncertainties:

 

•                  the need for our network securityproducts, regulated information compliance systems, entity identificationproducts and spyware products to achieve market acceptance and produce asustainable revenue stream;

•                  our ability to manage costs and expenses;

•                  our dependence on key personnel;

•                  our ability to obtain financing onacceptable terms; and

•                  our ability to offer greater value than our competitors.

 

                Ourbusiness strategy may not successfully address these risks.  If we fail to recognize significant revenuesfrom the sales of our network security products, regulated informationcompliance systems, entity identification products and spyware products, ourbusiness, financial condition and operating results would be materiallyadversely affected.

 

***We face intensecompetition from both start-up and established companies that may havesignificant advantages over us and our products.***

 

The market for networksecurity solutions is intensely competitive. There are numerous companiescompeting with us in various segments of the data security markets, and theirproducts may have advantages over our products in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

 

Our principal competitors in the network intrusionprevention and detection market include Internet Security Systems, Inc.(IBM), Cisco Systems, Inc., Symantec, Inc., Juniper Networks, Inc., McAfeeInc., Tipping Point Technologies, a division of 3Com Corporation, and NFRSecurity, Inc.  Our competitors inthe regulated information compliance market include Vontu, Port Authority(Websense), Vericept, Reconnex, Tablus and a small number of start-up companiesthat entered the space within the last two years. Regarding the spywareprevention market, we currently directly and indirectly compete with a numberof host-based spyware detection systems, such as Ad-Aware, Spybot S&D andSpy Sweeper and some inline proxy solutions such as Blue Coat Systems,Inc.  Our current and potentialcompetitors may have one or more of the following significant advantages overus:

•                  greater financial, technical andmarketing resources;

•                  better name recognition;

•                  more comprehensive security solutions;

•                  better or more extensive cooperativerelationships; and

•                  larger customer base.

 

 

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We cannot assure you thatwe will be able to compete successfully with our existing or newcompetitors.  Some of our competitors mayhave, in relation to us, one or more of the following: longer operatinghistories, longer-standing relationships with OEM and end-user customers andgreater customer service, public relations and other resources. As a result,these competitors may be able to more quickly develop or adapt to new oremerging technologies and changes in customer requirements, or devote greater resourcesto the development, promotion and sale of their products. Additionally, it islikely that new competitors or alliances among existing competitors couldemerge and rapidly acquire significant market share.

 

***If we fail torespond to rapid technological changes in the network security industry, we maylose customers or our products may become obsolete.***

 

The network securityindustry is characterized by frequent product introductions, rapidly changingtechnology and continued evolution of new industry standards.  We must also introduce upgrades to ourproducts rapidly in response to customer needs such as new computer viruses orother novel external attacks on computer networks.  In addition, the nature of the networksecurity industry requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop andintroduce in a timely manner new products and enhancements to our existingproducts that meet changing customer requirements and evolving industrystandards. The development of technologically advanced network securityproducts is a complex and uncertain process requiring high levels ofinnovation, rapid response and accurate anticipation of technological andmarket trends.  We cannot assure you thatwe will be able to identify, develop, manufacture, market or support new orenhanced products successfully in a timely manner.  Further, we or our competitors may introducenew products or product enhancements that shorten the life cycle of ourexisting products or cause our existing products to become obsolete.

 

***Our products are highlytechnical and if they contain undetected errors, our business could beadversely affected and we might have to defend lawsuits or pay damages inconnection with any alleged or actual failure of our products and services.***

 

                Ourproducts are highly technical and complex, are critical to the operation ofmany networks and, in the case of our security products, provide and monitornetwork security and may protect valuable information. Our products havecontained and may contain one or more undetected errors, defects or securityvulnerabilities. Some errors in our products may only be discovered after aproduct has been installed and used by end customers. Any errors or securityvulnerabilities discovered in our products after commercial release couldresult in loss of revenues or delay in revenue recognition, loss of customersand increased service and warranty cost, any of which could adversely affectour business and results of operations. In addition, we could face claims forproduct liability, tort or breach of warranty. Defending a lawsuit, regardlessof its merit, is costly and may divert management’s attention. In addition, ifour business liability insurance coverage is inadequate or future coverage isunavailable on acceptable terms or at all, our financial condition could beharmed.

 

***A breach of network securitycould harm public perception of our security products, which could cause us tolose revenues.***

 

                Ifan actual or perceived breach of network security occurs in the network of acustomer of our security products, regardless of whether the breach isattributable to our products, the market perception of the effectiveness of ourproducts could be harmed. This could cause us to lose current and potential endcustomers or cause us to lose current and potential value-added resellers anddistributors. Because the techniques used by computer hackers to access orsabotage networks change frequently and generally are not recognized untillaunched against a target, we may be unable to anticipate these techniques.

 

***If our products do notinteroperate with our customers’ networks, installations will be delayed orcancelled and could harm our business.***

 

                Ourproducts are designed to interface with our customers’ existing networks, eachof which have different specifications and utilize multiple protocol standardsand products from other vendors. Many of our customers’ networks containmultiple generations of products that have been added over time as thesenetworks have grown and evolved. Our products will be required to interoperatewith many or all of the products within these networks as well as futureproducts in order to meet our customers’ requirements. If we find errors in theexisting software or defects in the hardware used in our customers’ networks,we may have to modify our software or hardware to fix or overcome these errorsso that our products will interoperate and scale with the existing software andhardware, which could be costly and negatively impact our operating results. Inaddition, if our products do not interoperate with those of our customers’networks, demand for our products could be adversely affected, orders for ourproducts could be cancelled or our products could be returned. This could hurtour operating results, damage our reputation and seriously harm our businessand prospects.

 

***While we believe that wecurrently have adequate internal control over financial reporting, we areexposed to risks from recent legislation requiring companies to evaluate thoseinternal controls.***

 

                Section404 of the Sarbanes-Oxley Act of 2002 requires our management to report on theeffectiveness of our internal control 

 

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over financial reporting. We have an ongoing programto perform the system and process evaluation and testing necessary to complywith these requirements. We have and will continue to incur significantexpenses and devote management resources to Section 404 compliance on anongoing basis. In the event that our chief executive officer, chief financialofficer or independent registered public accounting firm determine in thefuture that our internal controls over financial reporting are not effective asdefined under Section 404, investor perceptions may be adversely affected andcould cause a decline in the market price of our stock.

 

***Our products canhave long sales and implementation cycles, which may result in us incurringsubstantial expenses before realizing any associated revenues.***

 

The sale andimplementation of our products to large companies and government entitiestypically involves a lengthy education process and a significant technicalevaluation and commitment of capital and other resources.  This process is also subject to the risk ofdelays associated with customers’ internal budgeting and other procedures forapproving capital expenditures, deploying new technologies within theirnetworks and testing and accepting new technologies that affect keyoperations.  As a result, sales andimplementation cycles for our products can be lengthy, and we may expendsignificant time and resources before we receive any revenues from a customeror potential customer.  Our quarterly andannual operating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

 

***Consolidation inthe network security industry may limit market acceptance of our products.***

 

Several of ourcompetitors have acquired security companies with complementary technologies inthe past.  We expect consolidation in thenetwork security industry to continue in the future.  These acquisitions may permit our competitorsto accelerate the development and commercialization of broader product linesand more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit ouraccess to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market shares, customerbases, sales forces, product offerings and technology and marketing expertise,which may make it more difficult for us to compete.

 

***We must adequatelyprotect our intellectual property in order to prevent loss of valuableproprietary information.***

 

We rely on a combinationof patent, copyright, trademark and trade secret laws, confidentialityprocedures and non-disclosure agreements to protect our proprietarytechnology.  However, unauthorizedparties may attempt to copy or reverse-engineer aspects of our products or toobtain and use information that we regard as proprietary.  Policing unauthorized use of our products isdifficult, and we cannot be certain that the steps we have taken will preventmisappropriation of our intellectual property. This is particularly true in foreign countries where the laws may notprotect proprietary rights to the same extent as the laws of the United Statesand may not provide us with an effective remedy against unauthorized use.  If our protection of our intellectualproperty proves to be inadequate or unenforceable, others may be able to useour proprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

 

***We may incur substantial expenses defending ourselvesagainst claims of infringement.***

 

There are numerouspatents held by many companies relating to the design and manufacture ofnetwork security systems.  Third partiesmay claim that our products infringe on their intellectual propertyrights.  Any claim, with or withoutmerit, could consume our management’s time, result in costly litigation, causedelays in sales or implementations of our products or require us to enter intoroyalty or licensing agreements. Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license the infringedor similar technology on commercially reasonable terms could seriously harm ourbusiness.

 

***Fluctuations in ourquarterly revenues may cause the price of our common stock to decline.***

 

Our operating resultshave varied significantly from quarter to quarter in the past, and we expectour operating results to vary from quarter to quarter in the future due to avariety of factors, many of which are outside of our control.  Significant portions of our expenses are notvariable in the short term and we cannot reduce them quickly to respond to unexpecteddecreases in revenues.  Therefore, ifrevenues are below our expectations, this shortfall is likely to adversely anddisproportionately affect our operating results.  Accordingly, we may not attain positiveoperating margins in future quarters.  Anyof these factors could cause our operating results to be below the expectationsof securities analysts and investors, which likely would negatively affect theprice of our common stock.

 

***The price of our common stock hasbeen volatile in the past and may continue to be volatile in the future due tofactors outside of our control.***

 

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future.  For 

 

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example, in the fiscalyear ended September 30, 2007, the market price of our common stock on TheOTCBB and The Nasdaq Capital Market fluctuated between $0.25 and $0.75 pershare.  The market price of our commonstock may fluctuate significantly in response to a number of factors, many ofwhich are outside our control, including:

•                  variations in our quarterly operatingresults;

•                  changes in estimates of our financialperformance by securities analysts;

•                  changes in market valuations of ourcompetitors;

•                  announcements by us or our competitors ofnew products, significant contracts, acquisitions, strategic relationships,joint ventures or capital commitments;

•                  product or design flaws, product recallsor similar occurrences;

•                  additions or departures of key personnel;

•                  sales of common stock in the future; and

•                  fluctuations in stock market prices and volume, which can beparticularly common among network security and other high technology companies.

 

***Our past reductionsin our work force may make it more difficult for us to attract and retain thepersonnel necessary to successfully operate our business.***

 

We rely upon thecontinued service of a relatively small number of key technical, sales andsenior management personnel.  Our futuresuccess depends on retaining our key employees and our continuing ability toattract, train and retain other highly qualified technical, sales andmanagerial personnel.  We do not haveemployment agreements with our key technical, sales and senior managementpersonnel.  As a result, our employeescould resign with little or no prior notice. We may not be able to attract, assimilate or retain other highlyqualified technical, sales and managerial personnel in the future.  The loss of any of our key technical, salesand senior management personnel or our inability to attract, train and retainadditional qualified personnel could seriously harm our business.

 

***Ouracquisition of complementary products or businesses may adversely affect ourfinancial condition.***

 

We have made acquisitionsin the past and, in the future we may acquire or invest in additionalcompanies, business units, product lines or technologies to accelerate thedevelopment of products and sales channels complementary to our existingproducts and sales channels.  Negotiationof potential acquisitions and integration of acquired products, technologies orbusinesses could divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***Compliance withexport regulations may hinder our sales to foreign customers.***

 

Certain of our datasecurity products incorporate encryption and other technology that may requireclearance and export licenses from the U.S. Department of Commerce under UnitedStates export regulations.  Any inabilityto obtain these clearances or licenses or any foreign regulatory approvals, ifrequired, on a timely basis could delay sales and have a material adverseeffect on our operating results.

 

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***Provisions of our charterdocuments and Delaware law may have anti-takeover effects.***

 

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our stockholders to act by writtenconsent, could make it more difficult for a third party to acquire us, even ifdoing so would be beneficial to our stockholders.  We are also subject to the provisions ofSection 203 of the Delaware General Corporation Law, which restrictscertain business combinations with interested stockholders and could inhibit anon-negotiated merger or other business combination.

 

***Military actions may disrupt ourbusiness by reducing spending on our products, increasing our costs andaffecting our international operations.***

 

United States militaryactions or other events occurring in response to or in connection with them,including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

•                  reducing or delaying government, militaryor corporate spending on network security products;

•                  increasing the cost and difficulty inobtaining materials or shipping products; and

•                  affecting our ability to conduct business internationally.

 

Should theseevents occur, our business, operating results and financial condition could bematerially and adversely affected.

 

Item 3.                                CONTROLS AND PROCEDURES

 

We maintain “disclosure controls and procedures,” asdefined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (the “Exchange Act”), that are designed to ensure thatinformation required to be disclosed by us in reports we file or submit underthe Exchange Act is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms, and that such informationis accumulated and communicated to our management, including our principalexecutive officer and principal financial officer, as appropriate, to allowtimely decisions regarding required disclosure. In designing and evaluating ourdisclosure controls and procedures, management recognized that disclosurecontrols and procedures, no matter how well conceived and operated, can provideonly reasonable assurance of achieving the desired control objectives, and wenecessarily are required to apply our judgment in evaluating the cost-benefitrelationship of possible disclosure controls and procedures.

 

Our management, including our principal executiveofficer and principal financial officer, evaluated the effectiveness of thedesign and operation of our disclosure controls and procedures as of September30, 2007 and concluded that the disclosure controls and procedures wereeffective.

 

There were no changes in our internal control overfinancial reporting that occurred during the quarter ended September 30, 2007that have materially affected, or are reasonable likely to materially affect,our internal control over financial reporting.

 

At the end of 2007, Section 404 of theSarbanes-Oxley Act will require our management to provide an assessment of theeffectiveness of our internal control over financial reporting, and at the endof 2008, our independent registered public accountants will be required toaudit management’s assessment. We are in the process of performing the systemand process documentation, evaluation and testing required for management tomake this assessment at the end of 2007 and for its independent registeredpublic accountants to provide their attestation report at the end of 2008. Wehave not completed this process or its assessment, and this process willrequire significant amounts of management time and resources. In the course ofevaluation and testing, management may identify deficiencies that will need tobe addressed and remediated.

 

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**PARTII — OTHER INFORMATION**

 

Item 1.                                LEGAL PROCEEDINGS

 

We are subject to legal proceedings and claims thatarise in the ordinary course of business. We do not believe that the outcome of those matters will have a materialadverse affect on our consolidated financial position, operating results orcash flows.  However, there can be noassurance such legal proceedings will not have a material impact.

 

 

Item 6.                                EXHIBITS

 

The following Exhibitsare filed with this report form 10-QSB:

 
| 31.1 |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                  |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                  |
| 32.1 |   | Certification Pursuant to Rule 13a-14(b) of the  Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

 

 

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**SI G N A T U R E S**

 

 

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 

 
| ** **             | **INTRUSION INC.**                                                         | ** ** |
|------------------------|----------------------------------------------------------------------------|------------|
|                   |                                                                       |       |
| Date: November 9, 2007 | /s/ G. Ward Paxton                                                         |       |
|                   | G. Ward Paxton                                                             |       |
|                   | Chairman, President & Chief Executive Officer                          |       |
|                   | (Principal Executive Officer)                                              |       |
|                   |                                                                       |       |
|                   |                                                                       |       |
| Date: November 9, 2007 | /s/ Michael L. Paxton                                                      |       |
|                   | Michael L. Paxton                                                          |       |
|                   | Vice President, Chief Financial Officer,

 Treasurer  & Secretary |       |
|                   | (Principal Financial & Accounting Officer)                             |       |

 

 

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